Pre-Retirees, Retirees Switch To Roth IRA

Converting a regular IRA to a Roth IRA brings a host of benefits. Unlike a traditional IRA, which requires you to begin withdrawing money from the account after you turn 70½, a Roth has no mandatory distributions. If you don’t need the money, you can leave it to compound for the rest of your days. Even better, if you’re at least 59½, any money you do take out—assuming it has been in the account five years or more—is tax-free. In contrast, withdrawals from a regular IRA are taxed as regular income.

So why doesn’t everyone convert to a Roth? One reason is the current $100,000 income limit for conversions. The other problem is taxes; to convert to a Roth, you must first take money out of your traditional IRA, and that means paying income tax. However, if you are in your 60s and have a low income and big tax deductions, a Roth conversion can be almost painless. You can make the switch without creating a huge tax bill, avoid paying taxes on much of your retirement income, and provide tax-free income for your heirs as well.

To see how this would work, consider Frank and Sylvia, a fairly typical couple on the verge of retirement. He is 61 and a hospital administrator; she’s a 55-year-old homemaker. They have managed to sock away $600,000 in Frank’s pension plan and $400,000 in regular IRAs. They have another $600,000 invested in tax-free municipal bonds.

Frank wants to retire this year, and it turns out that he and Sylvia are in an ideal situation to convert some of their IRA assets to a Roth. Not only are they far under the $100,000 income threshold, but also, like many people their age, they can control how much income they receive in a particular year. For instance, Frank can choose to delay receiving Social Security until age 65, and also can defer payments from his pension. Keeping your income down when you’re converting to a Roth IRA means that the money you pull out of the regular IRA will be taxed at a low rate or may not be taxed at all.

Apart from interest and dividends flowing from a savings account and investments in a few mutual funds, almost all the income Frank and Sylvia will receive after he leaves his job will be from their tax-free municipal bonds. They will have less than $10,000 of taxable income, and once their exemptions are figured in, that figure will drop to almost zero.

Meanwhile, the mortgage interest and property taxes Frank and Sylvia pay on their primary residence and vacation home provide a $40,000 annual deduction for the next several years. The perfect use for that deduction, which would otherwise go to waste, is to offset $40,000 a year in income from IRA withdrawals which can then go into a Roth IRA. If they do this for four years, until Frank reaches 65 and must start receiving income from Social Security and his pension, they’ll salt away $160,000 in the Roth IRA.

To give them the $85,000 a year they need to live on in the meantime, Frank and Sylvia can tap the principal from their $600,000 muni-bond account. Spending investment principal is psychologically difficult for some retirees, but in many situations it makes good financial sense.

In this case, selling some of their munis now helps Frank and Sylvia avoid taxes later. Once he reaches 65 and starts receiving Social Security and his pension, they are likely to be in the 28% tax bracket or higher. Money they take out from a regular IRA would be taxed at that rate, and after age 70½ annual withdrawals would be mandatory. That won’t be a problem with the assets they’ve moved into the Roth IRA; they won’t have to make withdrawals, but funds they do pull out are tax-free.

In addition, if Frank names his children beneficiaries of the Roth IRA, they will inherit a stream of tax-free income. According to Roth IRA rules, they can stretch out tax-free payments for the rest of their lives.

Future tax breaks: The $100,000 dollar cap for Roth IRA conversions is scheduled to be removed beginning in 2010. What’s more, for a conversion occurring in 2010, you can elect to spread out the resulting tax liability over the following two years.

This article was written by a professional financial journalist for Legend Financial Advisors, Inc. and is not intended as legal or investment advice.